Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

In case you didn't know, Ron Paul is a US Congressman who currently heads the House Financial Services Committee's subcommittee on monetary policy. I assume that this gives him some power to mobilize forces to implement his ideas. Paul is of course a vocal critic of the Fed. If there was good science backing up Ron Paul's ideas, and if the ideas were tight and well-reasoned, that would be great. Unfortunately, End the Fed which I take to be the best Paul can do in marshaling his thoughts, is for the most part bad science, consisting of flimsy arguments and some utter nonsense.

Now, to start, you should understand where I am coming from. I was not born in the United States, though I am currently a US citizen. For Canadians, coming to the United States and working here is relatively painless. For example, I look and sound like I could be from Minnesota, or the Upper Peninsula of Michigan (those people are essentially Canadian anyway - they even know how to hold hockey sticks). Sometimes I feel badly for some of my fellow immigrants, including the ones from Asia who have to struggle with the language, or those from Mexico who have to deal with this guy, but I digress. I got my first year-round job at the Bank of Canada in 1979, when I was 24. Since then I have worked full-time at the Minneapolis Fed (2 years), and have been a visiting academic at the Federal Reserve Banks of Richmond, Cleveland, Philadelphia, Kansas City, Atlanta, and New York. I currently spend an average of something less than one day per week at the St. Louis Fed, in my hometown, where my full-time job is at Washington University in St. Louis. My title at the St. Louis Fed is "Research Fellow," and I have an office over there (no window unfortunately) with my name on the door. I also know some powerful people. I went to graduate school with 2 Fed Presidents, know 4 Fed Presidents well (Narayana Kocherlakota is a rather aggressive poker player; Dean Corbae is not), and am an acquaintance of Ben Bernanke's from back in the day (e.g. we both belonged to Glenn Hubbard's NBER group for a time).

I'm not trying to boast here. As everyone knows, Canadians are trained not to do it (there are some exceptions - my friend Randy Wright has never been accused of excessive modesty). I may be slow at times, but surely after all this time hanging out with central bankers and working on the inside of their institutions I have some understanding of how central bankers think and how well they do their jobs. I also like to think of myself as an independent thinker. In this blog, I'll sometimes criticize people in the Fed when I think they need it. Some of that is in the spirit of this. Whether my ideas have any impact on how these people think about policy is a mystery to me.

Now, what is End the Fed about? The first paragraph of Chapter 10 (page 141) sums it up:

The Federal Reserve should be abolished because it is immoral, unconstitutional, impractical, promotes bad economics, and undermines liberty. It's destructive nature makes it a tool of tyrannical government.

Now, I'm sure that to some of you this sounds like a rant, but let's give the poor guy a chance, and consider the pieces of his argument.

1. The Fed is immoral. The idea here has to do with what Paul calls "printing money out of thin air." We have a government, and the government is a tyrant. The tyrant must confiscate resources in order to keep itself alive. To confiscate the resources, the tyrant can tax, issue interest-bearing debt, and also issue money, through the tyrant's central bank. When the tyrant taxes us, we can see what is going on. The thief is taking our stuff, but he or she is being pretty up-front about the whole thing. If the government borrows in order to acquire resources, then this is more indirect. The government debt issued to finance the tyrant's spending could actually just be deferred taxation (the government taxes us in the future to pay off the debt), and maybe we can figure that out, which is what Ricardian equivalance is all about. But if the tyrant simply uses its monopoly over the printing press to issue money in order to acquire goods and services, then the theft is even more indirect. As private citizens we are deprived of resources by the tyrant because the extra money issued by the tyrant drives up prices and makes our money worth less in terms of goods and services. Now, instead of a thief with the gall to steal our stuff in broad daylight, we have an underhanded, conspiratorial thief who walks off with our stuff in the dead of night. Not only that, but the thief is in league with rich bankers. Even worse.

Is the Fed immoral? Ron Paul wants you to think that what the Fed is doing is mysterious, secretive, and underhanded. We have all been hoodwinked but, according to him, he has figured it out, and will proceed to enlighten us. You can forgive Paul somewhat for the "printing money out of thin air" idea, as this is part of what is conveyed in conventional money and banking undergraduate courses. Indeed, Paul's exposure to formal economics training appears to be confined to a single undergraduate course, in which he seems to have been exposed to the money multiplier, probably the most misleading idea propagated in monetary economics. As discussed here, a central bank is best viewed as just another financial intermediary, the unique characteristic of which is that it has a monopoly on the issue of some class of liabilities. The Fed creates liabilities out of "thin air" to purchase the assets in its portfolio. A bank creates deposit liabilities out of thin air to purchase the assets in its portfolio. General Motors can create equity claims out of thin air to finance the purchase of new plant and equipment. Further, the fact that the liabilities of the Fed do not represent specific claims to anything in the future is neither here nor there. In private markets, in which Paul puts much trust, we have developed arrangements by which private firms issue claims (stock) which are not specific promises to pay anything specific in the future (dividends are discretionary). Further, private firms make no commitments about their future plans to issue more stock, or to buy back stocks, decisions which will affect the value of stock held by existing shareholders, just as decisions by the Fed affect the value of the existing stock of money outstanding. Nothing mysterious here at all.

Now, Paul seems very focused on inflation, and the resources extracted from the private sector by way of the inflation tax. It would help here to do some back-of-the-envelope calculations to get an idea of the magnitude of resource extraction. From fourth-quarter 2010 NIPA numbers, GDP was about $14.9 trillion, and total expenditures (by all levels of government) were about $3 trillion, at annual rates (seasonally adjusted), so the tyrant was extracting about 20.1% of GDP (this is all levels of government). Now, inflation has been hovering around 1% per year recently, but suppose it were 2%, which is the Fed's stated inflation target (not officially, but Bernanke says as much in public). What is seignorage, i.e. the implicit revenue the government collects, through the Fed, from the inflation tax? To calculate this, we need to know what the tax base is. Let's think of the current stock of reserves as essentially T-bills, which the Fed plans to retire in good time (to take it at its word). Then, the remainder of outstanding Fed liabilities is essentially currency (which certainly corresponds to Paul's language) which is just short of $1 trillion, so let's call it $1 trillion just for argument's sake. Then, with 2% inflation, the revenue from the inflation tax is about $20 billion per year, or 0.7% of government spending, or 0.14% of GDP. Small potatoes, and certainly not enough to justify an armed mob outside the Fed in Washington screaming "end the fed," as Paul seems to envision.

What is missing from Paul's arguments is some statement of principles about what the government should be doing. The best we get is this, on page 192:

When government grows, liberty suffers. This happens no matter what justification is given for the government programs financed.

Suppose I take this literally. Paul thinks liberty is good. More government means less liberty, therefore the optimal state of the world is one with zero government. But Paul also appears to be offended by theft, so surely he recognizes that there might be some problem in leaving policing to the private sector. Maybe he thinks that an army might be useful, if not for pursuing exploits abroad, then at least for defending us from invading Canadians. Once we recognize that there is some role for government, we are going to have to finance this government, and that will require contributions from all of us. There is then a whole branch of economics - public finance - that deals with the issue of how those contributions can and should be made, and the consequences of alternative means of resource extraction for the government. In primitive economies, where the costs of collecting taxes are high and financial markets undeveloped, it can be economically efficient for the government to generate much of its revenue with the inflation tax. In modern economies, we think not. We recognize that inflation is costly, and modern disciplined central banks keep inflation rates low.

2. The Fed is unconstitutional. I'm not a constitutional expert, by any means, but this argument seems to be coming from the same place as this, which does not quite say that the income tax is unconstitutional, but comes close. I know the idea is floating around. Get serious.

3. The Fed is impractical. Paul seems to think that the Fed is the wrong tool for getting the job done. What's the job that we want done? Apparently we want price stability, so let's take that as given. What is Paul's alternative to the Fed? He wants to go back to the good old days of the gold standard. So what's wrong with that? I discussed some of the issues here. Basically, if price stability is the goal, any commodity standard is incapable of delivering it. Here is what Paul appears to have in mind, though he is pretty vague about the whole arrangement. One of Paul's Austrian-economics heroes is Murray Rothbard, who wrote this. Rothbard thought the gold standard was a good idea, and also had a problem with fractional reserve banking. Basically, what Rothbard his in mind is some combination of the gold standard and Friedman's 100% reserve requirement on any transactions medium. Any liability used in transactions must be backed 100% by gold. Now, the key problem with this arrangement, aside from the usual difficulties with the fluctuating relative price of gold, is that there is not provision for "currency elasticity," a term written into the Federal Reserve Act of 1913. Currency elasticity is a concept you can teach to students in homework problems. Roughly, the demand for money will fluctuate due to fluctuations in various exogenous factors (time of day, day of the week, month of the year, productivity, transactions technologies, etc.). If the money supply does not accommodate these shocks, prices will fluctuate as well, and we will not have price stability. If all media of exchange are backed one-for-one with gold, then you get some elasticity due to the fact that gold can be diverted from other uses (and dug out of the ground) to use as backing for transactions media. But this necessarily implies that the relative price of gold is fluctuating and, by implication, there is no price stability. Further, restricting private financial intermediation with a 100% reserve requirement, while un-Libertarian and inconsistent with what Paul seems to stand for, is also economically inefficient - it works like a tax on financial intermediation. Theft, as it were.

4. The Fed promotes bad economics. How do you tell good economics from bad economics? Sometimes the profession gives prizes to people. There's the John Bates Clark Medal. There's the Nobel Prize. Two Nobel Prize winners were Ed Prescott and Robert Lucas, Jr. Prescott has had a long and fruitful relationship with the Minneapolis Fed, and Lucas has been a frequent visitor there. The collaboration between University of Minnesota economists and researchers working at the Minneapolis Fed produced some of the most important breakthroughs in 20th century macroeconomics. New Keynesian Economics was developed by people like Mike Woodford and Mark Gertler, who have ties to the New York Fed, and to other central banks in the world, including the ECB. Currently, there is first-rate research being done at all of the Federal Reserve Banks in the system, and at the Board of Governors in D.C., and some of those research groups would easily rank among the top 20 among working groups of macroeconomists in the world. Bad economics! What an insult! To do its job, the Fed needs to be on top of economic science, and I think it does a good job of that. A particular strength of the Federal Reserve System is its decentralization. A regional Fed President is appointed by the Board of Directors of the individual regional Fed (though the appointment must be approved by the Board of Governors), and regional Feds develop their own idiosyncratic views, with a healthy competition in ideas among the regional Feds, and between the regional Feds and the people in Washington D.C. No central bank in the world appears to be organized in a way that promotes this degree of diversity in ideas.

5. The Fed undermines liberty. What's that about? Summary:

Remember that the people who run the Fed are just regular people, as flawed as anyone else. The only difference is that they have massive power to break civilization. Any institution that can do this is by nature tyrannical and is specifically what the Constitution was trying to prevent.

I'm sure that Ben Bernanke does not look in the mirror in the morning and think of the guy he sees as being capable of breaking civilization. Central bankers may be powerful, but there's no need to go overboard here.

I have sometimes contemplated, in published papers, what the world would look like without a central bank, and how private arrangements might substitute for what the central bank does. It is important to question the existence of central banks, to put central bankers on the hot seat about their methods, and to work to improve central banking practice. However, I am convinced that, given what we know, getting rid of the Fed would be foolhardy. The science of economics is no different from any other science. Our understanding of central banking is imperfect, just as our understanding of cancer and global warming are imperfect. We have a pretty good idea about the broad outlines of what a central bank is good for, but about the details we are not sure. My judgment is that the world would be a much more unstable place without the Federal Reserve System than with it. Instability is a threat to our freedom, as events of the last 10 years should make clear. While Ron Paul might be able to convince me that we should end the Fed, my best guess is that he is not up to it.

84 comments:

You aren't the target audience of End the Fed. It's a popularization of Austrian Economics, with an emphasis on things that appeal to the masses (i.e. the constitution and "morality). If you want to read the economic aguments, read Microfoundations and Macroeconomics by Steve Horwitz, Time and Money by Roger Garrison, or The Theory of Free Banking by George Selgin. Here is a link to the last one: http://files.libertyfund.org/files/2307/Selgin_1544_Bk.pdf

Do you believe politicians who pursue "mainstream" economic policies like the stimulus to understand why they are doing what they are doing? Paul knows far more than most (all?) of them and he used his position as a politicians to spread the ideas of another school in their most comprehensible and popularly persuasive form.

I read your profile and I see that you are a PhD student interested in Austrian economics.

I've got 2 related questions for you. (And I am not trying to give you a hard time, I am sincerely curious.)

1) Where do you study graduate level econ that teaches Austrian economics?

2) Although there are lots of schools of thought on money-macro--neo-Keynesian, neo-classical, neo-monetarist--I can't think of any "Austrian" school economists who teach at a top 20 school. Can you name 3 or 4 for me?

Yes, I understand that I'm not the target audience for the book. It's intended to sell a particular policy proposal to the public. That's how I'm evaluating it. Is it honest? Is it well-informed? Is it clear? Is it right?

I think we should take stunt double at his word. In fact, I'm curious too. However, having never worked at a top 20 school myself, I'm sympathetic to the view that you can find good ideas almost anywhere, and you can find some pretty slow people at Harvard if you look. I went out to Colorado (Boulder) to give a talk a couple of weeks ago, and that was very stimulating. Some interesting people with good ideas. I also got to go skiing, which definitely can't happen in Cambridge MA, where I am at this moment.

I have read some early twentieth century Austrian work from Mises and Hayek and Rothbard's "Man, Economy, and State", published sometime in the 1960s I think. These "representative" Austrians were economists and libertarians. It seems like today most Austrians would characterize themselves as libertarian economists. The contemporary group blurs the distinction between positive and normative analysis, whereas the former group (at least early in there careers) saw policy advocacy and economic science as related, but ultimately separate enterprises.

That being said, the earlier Austrians, people like Bohm Bawerk and Menger significantly influenced economic thought. I find Austrian capital theory, and to a lesser extent their theory of entrepreneurship, to be insightful. In addition to the ideological hang-ups the main failings of Austrian macroeconomics are:1) Refusal to accept Rational Expectations2) A disdain for the methods used by most economists, i.e. econometrics, anything computational, and mathematical reasoning in general.3) A reluctance to debate any school of thought besides hydraulic Keynesianism.If honest Austrian economists reduced this dogmatism their work might be considered good economics, not just good Austrian economics.

Maybe, Rob, if you read some of the work by the dozens of practicing Austrian economists, some with jobs at PhD programs, who are actually engaging the profession on the topics that the profession is interested in, you might get a picture of Austrian economics that is not stuck in the 1960s. I guess the 10 or 11 sessions at the Southerns every year is just us debating the Keynesians.

Seriously. Where you get your vision of the modern Austrian school is something of a mystery to me as it so at odds with reality.

Stephen, I enjoyed this -- but why not take on someone your own size, like Lawrence White, writing on the innumeable strings tying money science to the institution of the Fed (are you claiming economists aren't human, influenced by group think, self-interest, self-selection, institutional filtering, etc.), as well as White's case for free banking.

Arnold Kling argues that the population of "scientists" working in contemporary macro suffers from massive founder effects (read some geographical Darwinian biology).

The supervision of three or four professors at two or three schools account for most all top macroeconomists at all of the top grad schools.

The notion that there is much scientific diversity in the population of young macro economists is not credible -- esp. when put up against the massive and intractible empirical and theoretical anomalies facing this "science" (e.g. the failed prediction of a Great Moderation, the failure to anticipate or explain the current boom and bust, the conceptual failure of the representative agent model, the failure to accomidate genuine uncertainy and fat tails, etc.)

Right Steve: its a matter of the arguments, not the person making them, and certainly not the place where the person works! As for Ron Paul, both Larry White and I (and Steve Horwitz, more recently) have spent a lot of effort--too much, I fear--trying to rebut his and his followers' claims to the effect that fractional reserve banking is fraudulent-immoral-inherently unstable and so on. Most recently I have an SSRN paper ("Those Dishonest Goldsmiths") refuting the myth that early goldsmith bankers lend depositors' cash without having had their permission, or the legal right, to do so. Of course we've also argued the advantages of free banking over central banking, so we're bound to think that in that regard Ron Paul's heart is in the right place, so to speak. But of course good sentiments and sound economic arguments aren't the same.

I also, on a different matter, don't recognize parts of Rob Lester's characterization of Austrians. In particular, I don't think they can be said to shrink from arguing with anyone--and especially any critics of Austrian economics. Hell, they are, on the contrary, one very pugnacious bunch!

Stephen, I think I asked you this awhile ago but how do you think your analogy between the fed and share issuance holds when the holders of fed securities are not as educated as investors are about shares issued by private companies. Seems to me there is a big difference and the fed is able to use instruments that the holders of dollars don't even know exist.

That's certainly my impression, but I see you're getting an argument from some of the other commenters. There is a classic Menger paper that says some interesting things about the origins of money. I don't have it in front of me now, but I think the idea was that government played a more important role in developing monetary exchange than Ron Paul, for example, would have us believe.

Steve,

It would help to give us some examples (names and papers). Who are the Austrians who are addressing issues in terms a modern macroeconomist would understand? My impression, like Rob's, is that the modern Austrian holds the technical language of modern economics in contempt.

Greg,

My guess is that I wouldn't have much to argue about with Larry White. I read his book on free banking in Britain, and liked it, and I met him once, but haven't kept up with his work.

On your last comment: What you are discussing are standard regularities in human behavior. This is not a particular fault of modern macroeconomics. Students want to work with the top people in the profession, as a seal of approval from one of those people is a ticket to a job in a top research institution. There are cliques. Prescott produced a lot of excellent students, in good part because that is Ed's strength. He is a first-rate advisor of PhD students, and gives his time generously. Sargent also is very good with students, and cultivates a first-rate collegial atmosphere with them. Students of Lucas are harder to find, though personally I think the guy is a first-class human being, and I have learned a lot from talking to him. I'm a counter-example to what you're talking about. I worked with Mark Gertler and Rao Aiyagari when they were young unknown assistant professors at the University of Wisoconsin, and I don't think I ever suffered for it.

"The notion that there is much scientific diversity in the population of young macro economists is not credible..."

I don't think this story about ending central banks has any traction anywhere else on the planet. It is testimony to the very vivid imagination of the right wing in America. There is indeed something different about America, that seems to spawn cult-like beliefs like you can find nowhere else. A fascinating study for cultural anthropologists.

Wow, I must have hit a nerve. I had no idea that I was making an ad hominem attack on "increasingmu." Although I thought that I was polite, I apologize to Mr. or Miss Mu if he/she was offended.

My intention was to just ask who the top Austrian economists are. Whom should I read? Whose web page should I visit? For whom should I look at conferences? Which journals cater to Austrians? Where are the Austrians on this list?

You wrote "It is testimony to the very vivid imagination of the right wing in America. There is indeed something different about America, that seems to spawn cult-like beliefs like you can find nowhere else."

Respectfully, I must beg to differ that the United States or its right wing are unique in these cult-like beliefs.

People all over the world hold beliefs that are completely bizarre and unsupported by data. The stories differ from culture to culture but all cultures have them, as far as I know.

Many of the stories revolve around evil conspiracies--usually of powerful foreigners or a different ethnic group--that control society and the media, creating or preventing revolutions, "supporting" bad governments, etc.

For example, in the most recent revolts in the mid-east, both sides in several countries accused the other side of being controlled by Israel.

The United States might be different in that it is so externally secure that the evil conspiracy has to come from within, from the supposedly secretive and evil central bank.

1) "General Motors can create equity claims out of thin air to finance the purchase of new plant and equipment."2) "Further, the fact that the liabilities of the Fed do not represent specific claims to anything in the future is neither here nor there."

You're right about #1. Just as GM's new equity claims are backed by GM's newly bought assets, the Fed's newly-issued dollars are backed by the Fed's newly purchased assets.

Wrong on #2 though. Prior to 1933, the fed would buy back its dollars with gold, bonds, or other assets like buildings, furniture, foreign currency, etc. Each of those items provided a channel through which Fed dollars could reflux to the Fed.

In 1933, the Fed closed ONE channel of reflux--the gold channel--while leaving all the others open. Dollars can still reflux to the Fed for bonds, buildings, furniture, etc., and if the Fed were ever liquidated, the Fed could, and probably would, use all of its assets to redeem all of the dollars held by the public.

Modern monetary theory commits the error of observing that the dollar is inconvertible into gold, and concluding that the dollar is unbacked.

I think you are giving shareholders a lot of credit. Do you think your average shareholder of Bank of America stock knows any more about what is going on at the Bank of America than your average Federal Reserve noteholder knows about the Fed? Mostly, the Bank of America shareholder is just watching the share price, just like you are watching the prices of goods and services.

"I don't think this story about ending central banks has any traction anywhere else..."

Part of what is interesting about living in the United States is all the energy and creativity that is floating around. Sometimes it runs amok though, and that can be scary, as in this case. Stunt double is right, of course, that paranoia exists everywhere in the world. It's just due to ignorance, though, and we know how to fight that.

Mike,

Yes, exactly. All I meant to say that it is not written on a Federal Reserve note what it is a claim to. Of course the assets backing the liabilities is what matters, and what this entity plans to do with those assets. You get quite different effects if you buy T-bills with outside money and keep rolling them over, vs. buying some mortgage-backed securities and letting them mature.

A real "case against the Fed" has less to do with the institution's threat to price stability. Instead, the critique should focus on the Fed's accumulating impact on the stability of the financial system.

The economic arguments in favor of Fed actions to stabilize the economy largely ignore the costs. Repeated Fed attempts to deliver arbitrage opportunities to financial speculators (i.e. "extended period" on rates) promote two things: 1) homogeneous financial strategies across large firms; and 2) a large reduction in insurance against liquidity and maturity risk. Both of these factors lead to system fragility and exponentially heighten systemic risk -- to the point where a benign event (flattening of house prices) can jeopardize the system. The problem with this trend is that it is cumulative: the longer it goes on for, the more fragile the system becomes, and the higher the downside in the event that it fails. This passes largely unnoticed by most economists.

Yes, ultimately, the financial system's failure might force the Fed to abandon its policy of price stability for a time. This is a characteristic of financial crises that are followed by sovereign credit crises.

Depends on what you mean by "quite different effects". If $100 of paper money is issued for $100 worth of bonds or mortgages, and if they are continually rolled over, then you continually have $100 of assets backing $100 of liabilities, and the money holds its value.

If those bonds or mortgages mature after 1 year, and are paid off in those same dollars, then those dollars will hold their value for 1 year, at which point the dollars disappear, presumably to be replaced by some similar currency.

Something to think about: Nineteenth century bankers routinely claimed that their issuance of paper dollars was not profitable, since the interest they earned was more than offset by the costs of printing, handling, chasing counterfeiters, etc. The same might be true of the Fed, in which case there is no inflation tax.

You seem to agree that the dollar is not fiat money, and that already puts you at odds with 99% of what is in the textbooks. Now, since fiat money is money whose whole value is seignorage, we might start to wonder: If the dollar is not fiat money, might it also not create any seignorage?

I think we have discussed this in some form before. We could think about what the Fed does as providing insurance. In the absence of the insurance, the private sector would be self-insuring, but with the insurance they count on the Fed to do the right thing. But what happens if something unanticipated happens, the private sector is waiting for the Fed to do the right thing, but the Fed has no clue what the right thing is? Could we do better if the Fed's hands were tied in some way, for example with an explicit inflation target? Is this what you have in mind? I think this is well worth pursuing, and we should be quantifying these effects.

last anonymous:

Libertarian does not necessarily mean nutty, and I think some questions and pressure coming from the extreme laissez-faire camp are useful. We need to ask searching questions about what the government should and should not be doing, and how its activities are to be financed. That said, we want to do the "searching" using sound economics. Your view is that Libertarian ideas are spreading rapidly. The ideas have always been there. Do you think we are just hearing more about them?

Mike,

Yes, the dollar is not fiat money, which is unbacked paper issued by the government which will remain in circulation forever. A number of people tried to explain the anomaly you mention, which was the apparent unexploited profit opportunity that appeared to exist in the National Banking era to issuing a National Bank note. Can't remember what the upshot of all that was. I think there was basically just a limit on the quantity of notes that the National Banks could keep in circulation. You may see a profit opportunity, but the only way to exploit it is by keeping the notes out in circulation. The problem is that people keep redeeming the stuff.

A symmetrical inflation or NGDP targeting regime might tie the Fed's hands and lead to more private self-insurance. However, it is likely that the Fed will abandon its target in the face of high unemployment. Symmetry may not be a credible policy alternative in the face of a drop in trend RGDP growth.

A broader question is whether the Fed should reverse its policy of increasing transparency. Arbitrage opportunities (Fed-insured) are an artifact of the Fed wanting to use speculators as the main transmission channel for policy. In an environment where shadow banks are all "closet" speculators, this is dangerous. A policy of pre-Greenspan opacity, as retrograde as it must seem, could be a "least-worse" solution. The trade-off would be between a less efficient transmission of policy and a more robust financial system. IMO, it comes down to exactly how much RGDP stability the Fed thinks it can engineer. Scaling down this expectation might be ideal; however, the Fed seems to be going in the opposite direction.

One point to note: In your inflation calculations, you might take account of the fact that a considerable portion of US currency (maybe half or more?) is held by foreigners outside of the US. Therefore the inflation tax falls rather heavily on a group that Americans should want to tax, non-Americans. That transfer from foreigners to Americans makes it a rather attractive tax, especially at low levels.

Another thing: You mentioned Dean Corbae in the same breath as Narayana Kocherlakota when discussing Fed presidents that you know. I think that you slipped a cog, Dean is not an FRB president. Am I missing something?

I've never understood the argument for the NGDP rule. It's just a special-case Taylor rule. I think explicit inflation targeting is the way to go. This has been implemented elsewhere, and seems to work well. Impose that, along with some leeway for a lender-of-last-resort facility, and I think things would be fine. I think you are correct that the Fed is moving in the direction of playing up its perceived control over real activity.

Chris,

Hopefully no cogs have slipped. I checked and everything seems in place. Yes, that wasn't clear was it? When Narayana and I were at Iowa, Narayana liked to play cards. We would come over to his house to humor him and gamely play poker, but most of us were not very good at it. Narayana was very aggressive, and tended to win. Corbae was remarkably risk averse and would always fold when anyone made a serious bet. The game theorists couldn't seem to apply what they knew.

No, they're not saying they are redeemable. If I understand them correctly, they are saying that the critical things determining the value of Federal Reserve Notes are the assets in the Fed's portfolio (the "backing" for the notes), and what the Fed plans to do with those assets in the future.

Yes, I should have added that. How the liabilities are used in exchange is also important. Fiat money (unbacked intrinsically useless objects which, in basic monetary models, is what we typically deal with) can of course be valued, as you say. Speaking for Mike, what he is saying is that, in practice what the Fed issues is not fiat money, and that the backing is important.

Us dollars are redeemable for the Fed's bonds and other assets. Of course, both the bonds and the dollars are acceptable by the government for tax payments, so the dollar is ultimately backed by the government's ability to take real resources from us in the form of taxes.

I sometimes issue money in the same way that the government does. I'm a landlord, and I sometimes buy groceries by writing out a paper "Mike dollar" that I accept for $1 of rent. I'm told that my Mike dollars sometimes pass through several hands before returning to me. They are backed by my rent collections in the same way that Fed dollars are backed by tax collections.

One of these days, I'll buy another rental house by issuing a $200,000 bond. If I then issue some more Mike dollars and use them to buy back a few dollars' worth of my bonds, then I'd be doing exactly what the Fed does when it buys US government bonds. I wouldn't be surprised to hear someone complain that Mike dollars are convertible only into Mike bonds, which are in turn only convertible into Mike dollars, but the absurdity of that is obvious.

My position might be more extreme than Stephen thinks. I think there is no such thing as fiat money. A true fiat money would create a free lunch for its issuer and attract rival moneys until the value of the money was driven into line with its backing (zero). If true fiat money existed, we should find some money-issuers around the world who hold no assets against their money, but all the moneys I've ever heard of have clearly identifiable backing. I'm always amazed at how easily economists accept the idea of fiat money when they cannot point to a single example of it.

Steve,are you sure of what you say?you say the dollars the FED prints are backed by US governemnt bonds. Did you notice that tahy are ultimately backed by taxation? That is by US citizens (and GM as well)future income?The equity GM issue are in guaranteed by GM assets that is by ITS (not US citizens') future income Moreover do you use GM stocks to pay your bills?

I would be cautious to say that Paul sounds like an undergraduate if you start from these premisesBye

Right now I'm looking at the snow coming down outside. From here it all looks white to me (and rather blurry - I don't have my glasses on), but up close all those flakes are different. To dogs, all humans look the same. Why are you so grumpy about macroeconomists? Did we do something to you?

"I would be cautious to say that Paul sounds like an undergraduate if you start from these premises"

I just finished grading some stuff my undergraduates handed in. Some of them have the makings of first-rate economists. Relative to that group of people, you are rather confused, and struggling. Paul would have some difficulty too, I think. There's hope for you though. Start by reading my next post on Ricardian equivalence.

this is not an answer. On the contrary it seems that if you think and teach that monetizing government or government guaranteed debts is equivalent to issue equity and bonds there are many people confused. I tried to explain why while you just refer to other posts. By the way this is also why the FED (that is the government) in doing so is immoral and why is bad economicsIf you have arguments stick to the point otherwise do not offend Hope you understandThanks in advance

"Why are you so grumpy about macroeconomists? Did we do something to you?"

Two reasons, of different kinds.

1. I don't think macroeconomists are giving us science -- or even good explanations -- but they are representing themselves as doing so to students, governments, and the general public.

2. You guys have played a leading role in booming and then crashing my neighborhood -- I live in Ladera Ranch, CA, "Zombiland" described in _Money_ magazine. Friends and neighbors have been bankrupted, a good half of my block has been turned over.

At one point mortgage origination fraudsters put drug using prostitutes on my street in a house that had doubled in price and then dropped in half in a handful of years.

I'm a philosopher of science -- and I don't like the arrogant claim to "science" among folks with a patently absurd understanding of what "science" is or how to do it.

And I don't like what you guys have done to my country and my neighbor hood on the basis of fake science, produced by a narrow, closed guild, with only very rare self-reflection or humility.

Stephen, decades ago the AEA committee on graduate education pointed out the pathologies of econ graduate education -- David Colander has well documented the "rocket science" / "math jock" mentality of that education.

The top grad schools eliminated the history of economic thought decades ago, the ideal candidate for econ grad school is a physics major or a math major. The AEA committee of 20 years ago was already describing the typical grad school graduate as an "idiot savant" who know little or nothing of the real world, and who knew little economics outside of his hyper math intensive coursework.

And the profession for decades has worked within the fake science legacy of Paul Samuelson and Milton Friedman, who convinced the econ profession that some combination of the philosophical traditions of operationalism, instrumentalism, Machian positivism, and "Popperian testing" was the way to do "real science".

Does Raghu Rajan know what he is talking about? Rajan claims toidentify a cookie-cutter snowflake problem among macroeconomists -- just one of many:

"Like medicine, economics has become highly compartmentalized – macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, in order to see the crisis coming, you had to know something about each of these areas, just like it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields."

Why was BIS chief economist William White such out outlier in the profession -- correctly identifying the pathology of the boom and diagnosing the inevitability of the bust. And why wouldn't anyone in macro community listen to White or take his diagnosis seriously?

Why did the profession ignore Ed Leamer?

Etc.

As I say. These are central questions that demand explanation.

I don't see that the macro profession is very seriously addressing the foundational and institutional problems of the science.

Imagine, Stephen, if there were rocket scientists down the street following a patently "cargo cult" scientific "method" who were wiping out the homes and businesses of your neighbors.

Would you be, maybe, just a bit grumpy about it?

1 in 10 of my neighbors hasn't made their last mortgage payment. The local business district is full of shuttered small businesses. The school fired my daughters teacher last year -- do to insufficient funds, caused by a collapse in tax revenue.

Grumpy. Well, a bit.

Stephen wrote,

"Why are you so grumpy about macroeconomists? Did we do something to you?"

1. I hope you realize that modern macroeconomists neither designed the US financial system (for the most part), nor did they give California a dysfunctional state government. All in all, you are conforming to Rob Lester's view (above) of modern Austrians.

2. Bill White was my first boss. A rather charming guy from Kenora, Ontario. I like Leamer - interesting ideas.

"It would help to give us some examples (names and papers). Who are the Austrians who are addressing issues in terms a modern macroeconomist would understand? My impression, like Rob's, is that the modern Austrian holds the technical language of modern economics in contempt."

Hi Stephen, check out George Selgin's two papers "Adaptive Learning and the Transition to Fiat Money" and "Still Searching for a Theory of Fiat Money: A Commenton Kiyotaki and Wright".

My understanding is that George considers himself more of a "fellow traveler" than an Austrian. Nevertheless, I would be curious what you think about these Austrian-like efforts to speak in the lingo that your crowd has created.

I have not read George's papers, but he wrote some comments on my post about "Ron Paul and the Austrians." I learned some things from him, and we have much in common. Obviously he reads widely and has an open mind.

And the relations of interconnected heterogeneous production processes taking more or less time inter-relates with heterogeneous labor is mathematically intactable.

So at the core of economics are causal phenomena most economists botch due to their misuse of mathematics.

Perhaps if they respected mathematics as much as I -- and they didn't fear the cargo cultist who abuse mathematics, math would be use always for benign purposes, and not as a witch doctor's incantation justifying fake "scientific"'uses of math (and statistical tools, etc.).

If you are saying the Fed (and the macro community both populating policy roles and providing the background of scientific opinion legitimizing policy) is in no way responsible for the malinvestment boom and bust, say that.

"And the relations of interconnected heterogeneous production processes taking more or less time inter-relates with heterogeneous labor is mathematically intactable."

You're actually describing a set of models that modern macroeconomists are working with. In fact, this is not intractable. Mathematics is a powerful tool, which allows you to be precise about your economic arguments in an efficient way. That's why we require students to know some before they enter PhD programs in economics. You're having trouble articulating your ideas, and understanding modern macro, in part because you (seemingly) did not learn your math.

That's why they are rediscovering entrepreneurial learning, judgment, and adjustment, and writing books on it.

It's why they are rethinking the pathopogies of insight produced by representive agent models, by "K", by math models of risk and finance -- patholologies operationalized by money losing quants on Wall Street.

And why have these (now suspect) things taken up the core of econ? for no other reason thqn because they make things mathematically tractable.

It's not me who is making this argument, it is leaders in your own science.

Sponsored by the Program for Economic Research, Department of Economics

and Columbia Business School

Faculty House, Columbia University

Friday, February 11, 2011

Organizers: Ricardo Reis and Michael Woodford

Conventional models in both macroeconomics and finance are based on the hypothesis of rational expectations, under which all agents are assumed to have common expectations, corresponding to the probabilities implied by the economist’s model. The adequacy of this familiar hypothesis has been called into question by recent events, however, notably the instability resulting from the boom and bust in real estate prices. The purpose of this conference is to bring together researchers exploring alternative approaches to modeling the dynamics of expectations, with particular attention to applications in macroeconomics and finance. We have sought to bring together proponents of a variety of approaches, who may not frequently engage one another, in the hope of reaching conclusions about which directions are most promising at this time.

All well and fine from all you eggheads out there. My wife and I are on a fixed income and are heading to FRY's to get groceries. INFLATED groceries. Bust and Boom, yea right. With all the flying Ben has been doing, the cash is not here. By the way Stephen, no money for poker here either. Any ideas on how to survive the increased cost of living.

I understand your concerns. When I get the latest numbers on Friday I'll write something on the Fed and inflation. Though I don't think Ron makes any sense, I'm a Fed critic too. No sense ending the institution, but it can indeed work better.

Stephen, so you've got nothing -- nothing but changing the topic and insults?

You won't discuss William White, you won't discuss the work of Lawrence White on the Fed, you won't discuss the work of Frydman, Buiter, Bhide, Woodford, and Caballero on the limitations of the current fashions in math modeling.

Stephen, it turns out you are one of the critics of the cargo cult of maths:

"Fannie and Freddie, like all other large financial institutions, played important roles in the financial crisis. Can we quantify those roles? Because of the complicated relationships among financial institutions, I think this is impossible."

Really? You begin your argument against a certain viewpoint with which you disagree by priggishly dismissing the influence of an obviously influential person. Very powerful opening.

Dr. Williamson, in case you didn't know, Thomas Paine was an 18th century pamphlet writer.

By the way, if I were a Ph.D. scientist interested in displaying a superior point of view, I would at least attempt to be cognizant of proper grammar. Maybe you could take a break from the mental gymnastics of justifying the confiscation of wealth through making the money--not to be confused with making money--and focus on the conditional subjunctive and comma usage. Just a suggestion.

Actually, even though I know better, I took a look at the link above. Is this guy Dr. Williamson a serious academic? He can't develop an argument nor can he properly write a sentence.

Mr. Wenzel, if this is your competition in the marketplace of ideas, business is good. I left the following comment on his blog.

Is this a serious sentence:

In case you didn't know, Ron Paul is a US Congressman.

Really? You begin your argument against a certain viewpoint with which you disagree by priggishly dismissing the influence of an obviously influential person. Very powerful opening.

Dr. Williamson, in case you didn't know, Thomas Paine was an 18th century pamphlet writer.

By the way, if I were a Ph.D. scientist interested in displaying a superior point of view, I would at least attempt to be cognizant of proper grammar. Maybe you could take a break from the mental gymnastics of justifying the confiscation of wealth through making the money--not to be confused with making money--and focus on the conditional subjunctive and comma usage. Just a suggestion.

Scott you are pathetic. I left a post on this site yesterday. It was neither slanderous nor profane, but nonetheless it was not positive. I returned 30 minutes later to find that, despite the fact that there were other replies to it, you had deleted it. This tells me the following:

You are so consumed with vanity that you return to this altar you have built to worship yourself, at least twice an hour. For a man proclaiming to be so important and involved in such big things, you don't seem to have much to do

Furthermore, it becomes a hard sell for anyone to hear you talk about your superior knowledge when you are so afraid of the truth and honest discussion that you are censoring posts that don't fit your viewpoint.

And its even sadder that you do this in an effort to portray some false image of how your pseudo-intellectual ramblings are received by the general public. Are you so desperate for validation that you find consolation in misleading into believing that you are highly esteemed by the general public? (or "anonymous" as the case may be, assuming that "anonymous" is not actually you).

Since you love academia so much and have such respect for Ph.Ds, here's a nugget for you. A great and wise Ph.D once devised the pyramid of self realization. And at the top of that pyramid was the self realized person. And to get there you had to rise above seeking the validation of others.

So its really sad that for all the accolade and praise you give yourself over your long career, that you are still a mental infant seeking mommy's approval from people that aren't your mommy. To the point of having to lie and censor to make yourself believe that mommy loves you.

I have never seen a smaller more pathetic person. And the degrees, braggadacio and insults aren't fooling anyone. You didn't predict the end of the housing bubble, but I did. You didn't predict the Wall Street crash, but I did. You didn't buy a bunch of New Zealand dollars at 75cents per, but I did. I'm a chemist and my economics are batting 1.000 while you're here claiming superiority after a run of tragic and inexcusable failures.

But clearly you need to do this, lest you be made to look publicly the way you so obviously feel privately. Small and pathetic and afraid. Do you really think you are fooling anyone?

Stephen, when I buy a bond from the McDonalds, the money supply does not increase. When the Fed buys a bond, the money supply does increase. That's one significant difference.

A second significant difference is that when I buy the bond, I will typically liquidate some other asset first. (Otherwise, my cash balances, relative to my income etc., will decline below my normal desired level of cash balances.) If I liquidate an Apple bond, then that's going to slow activity in the computer sector and at the same time balance it with increased activity in the fast food sector. There's an inflationary effect on prices for fast food and a deflationary effect on prices for computers.

When a bank creates money to buy a bond from McDonalds, there is no immediate coupling to another sector. That comes later, as inflation, and it is spread out over all sectors. That's why the Fed's enabling of banks to create money out of thin air is inflationary.

But money is just a name. What makes the McDonald's bond less monetary than the Federal Reserve note? Both of these things are traded around. I could buy the McDonald's bond by drawing down the balance in my checking account. I can also "buy" Federal Reserve notes by drawing down the balance in my checking account when I go to the ATM.

The Fed does not "enable banks to create money out of thin air." A commercial bank does not need any OK from the Fed to issue liabilities. If you mean that reserve requirements constrain banks, that is not true any more. With the advent of sweep accounts, reserve requirements no longer effectively constrain financial institutions. Actually the Fed now has the power to get rid of reserve requirements - a good idea as this is just an inefficient tax on banking.

Stephen, I can't buy groceries with a McDonald's bond, just to mention one obvious difference between money and a bond.

Banks still need reserves even if the Fed doesn't require that they have them. For example, if I try to cash a check at my bank, they have to give me cash. They better have reserves in cash. They can't just give me another check, drawn on themselves. Likewise, if I try to transfer funds to another bank, my bank better have reserves. Banks that can't meet their obligations with reserves (cash or deposits at the Fed) are closed.

Hence, effectively, there are reserve requirements and at some point to expand their loan portfolio (create additional money out of thin air) a bank will need additional reserves (as a practical matter to avoid the risk of being closed).

The Fed provides through its purchase of bonds from banks, the reserves the banking system uses to expand its loans. That is how it enables the banks to create more liabilities - money out of thin air.

"Hence, effectively, there are reserve requirements and at some point to expand their loan portfolio (create additional money out of thin air) a bank will need additional reserves (as a practical matter to avoid the risk of being closed)."

Yes, in the sense that any retail business needs to keep cash on hand.

"Further, restricting private financial intermediation with a 100% reserve requirement, while un-Libertarian and inconsistent with what Paul seems to stand for, is also economically inefficient - it works like a tax on financial intermediation. Theft, as it were."

OK, I've established that the Fed by increasing its liabilities can increase the reserves of the banks, who can use their increased reserves to create liabilities that increase the money supply.

I've also established that there are two fundamental differences between the creation of a liability by a bank when it buys a McDonald's bond and when I buy one. The first is that the bank's creation of a liability increases the money supply, whereas mine does not. The second is that the bank's purchase of a bond leads to inflationary pressures (on prices) in one sector without balancing deflationary pressures in another sector as occurs in the case of my purchase of a bond. That's why Fed can use open market purchases to increase the rate of price inflation. This tends to raise the prices of nearly all products, while my private action does not increase the money supply and tends not to raise the general price level, because the inflationary effect in one sector is balanced by a deflationary effect in another sector.

I was just trying to make the point that the 100% reserve requirement that you find in Murray Rothbard's writings is actually very un-Libertarian. The ideas are very intellectually confused. One principle of Ron Paul and the Austrians is that they do not like taxation, large government, and interference with private activity. The 100% reserve requirement effectively interferes with private financial intermediation and works like a tax. The tax effectively "steals" from private financial intermediaries, but no one actually gains from it. This is pure social loss. With the income tax, for example, the government gets some revenue, and the social loss is some distortion in private decisions that results - you may reduce the incentive to work hard for example.

The post is so scattered with common places and misinterpretaions that one wonders what is its real purpose. Fortunately someone has already invited Williamson to read somethning in Austrian economics before trying to disparage it

However here are some easy to follow considerations which easily show Williamson’s inconsistencies

1. The Fed is immoral? Of course it is! It is to be asked? I leave it to each of you to define how to call the destruction of savings and wealth transfer by printing money out of nothing. Of course then “the Fed is doing is mysterious, secretive, and underhanded”. If Williamson dares to deny that does he know where all those trilions of dollars that the Fed has printed have gone? Why some banks and companies were allowed to fail and others saved? The Fed has lent money to foreign countries? Under what conditions and terms? It seems to me that Williamson is not aware of what he says when he states "central bank is best viewed as just another financial intermediary, the unique characteristic of which is that It has a monopoly on the issue of burdens class of liabilities." Wow!!! Could that monopoly be granted to me too? Has Williamson noticed that if he start doing what the Fed does ends up in jail? Contrary to what he belives (point 5 of Williamson’s post) , this also explains why when the government grows, liberty is compromised and society is split into subjects and kings in the longer run deposts.

2. Is the FED uncostitutional? Williamson begins by stating that he is not a constitutional expert. But then how can he pontificate about that? For Jefferson a staunch supporter of limited government, free trade and perhaps the real father of the constitution a central bank was unconstitutional and if I remember correctly he was the one that shut down to the one created to finance the war of independence (... just another reminder of morality of central banks). He had fully understood that any central bank is an inflationary machine serving the interests of politicians and the politically connected . Just what the Fed has shown to be in recent years by monetizing huge portions of the government debt and financing without limit major banks and groups at zero interest rates while the average American lost everything. Williamson should know that until the civil war it was the prevailing opinion that the powers granted to the government were only those expressly mentioned in the constitution and a central bank was clearly against his dictation.

3. The Fed is impractical? Williamson here refers to the mandate of the Fed "We want price stability". It is worth to remember that it is not the only one and seems that Williamson really believes that printing money and manipulating interest rates means wealth creation. The fact is that the Austrians have clearly explained (Hayek got a Nobel Prize for his studies on the business cycle) that price stability is a serious blunder and implies unintended consequences: it generates boom and therefore sooner or later bust. In other words, an economy that grows, necessarily shows falling prices and therefore consumers (including the poorest part of the population) exploit productivity gains in full. Contrary to the usual lithany, see for example the period between 1870 and the invention of the Fed when the U.S. probably experienced the highest increase of GDP per capita in their history. So…yes the Fed promotes bad policies (point 4 of the original post)

I a’m not sure why Williamson tries to caricature Ron Paul. Maybe it's just intellectual laziness or is that like many economists Williamson live on public money?